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Monetary Policy with 100 Percent Reserve Banking: an Exploration

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Monetary Policy with 100 Percent Reserve Banking: an Exploration NBER WORKING PAPER SERIES MONETARY POLICY WITH 100 PERCENT RESERVE BANKING: AN EXPLORATION Edward C. Prescott Ryan Wessel Working Paper 22431 http://www.nber.org/papers/w22431 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 July 2016 The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2016 by Edward C. Prescott and Ryan Wessel. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Monetary Policy with 100 Percent Reserve Banking: An Exploration Edward C. Prescott and Ryan Wessel NBER Working Paper No. 22431 July 2016 JEL No. E4,E5,E6 ABSTRACT We explore monetary policy in a world without fractional reserve banking. In our world, banks are purely transaction institutions. Money is a form of government debt that bears interest, which can be negative as well as positive. Services of money are a factor of production. We show that the national accounts must be revised in this world. Using our baseline economy, we determine a balanced growth path for a set of money interest rate policy regimes. Besides this interest rate, the only policy variable that differs across regimes is the labor income tax rate. Within this set of policy regimes, there is a balanced growth welfare-maximizing regime. We show that Friedman monetary satiation without deflation is possible in this world. We also examine a set of inflation rate targeting regimes. Here, the only other policy variable that differs across regimes is the inflation rate. Edward C. Prescott Arizona State University Economics Department P. O. Box 879801 Tempe, AZ 85287-9801 and NBER [email protected] Ryan Wessel Arizona State University Economics Department P. O. Box 879801 Tempe, AZ 85287-9801 [email protected] Section 1: Introduction The purpose of this paper is to open a discussion on monetary policy reform in light of advancements in information processing technology. Currently, there is public discussion about whether the interest rate should be increased and what the inflation rate target should be. Our assessment is that existing monetary theory does not provide predictions about the consequences of these and other alternative monetary policy regimes. We consider a particular monetary system with (i) interest-bearing money and (ii) a prohibition on financial institutions that borrow from one group at a low interest rate and lend to another at a higher average interest rate, thereby realizing positive net interest income. One question we will explore is the feasibility and desirability of Friedman monetary satiation. A prior question is whether following the Friedman rule is feasible in our current fiat money system. McAndrews [2015] has argued—and we think convincingly—that it is not feasible. He points out that people would not invest in securities that bear negative nominal interest rates because they could invest in currency, which bears a zero nominal rate. With our alternative monetary system, monetary satiation is feasible, even with a non-negative inflation rate. In the alternative monetary system considered in this paper, a bank is a business that issues demand deposits. Commercial banking companies in the United States and most other countries offer a wide range of financial products in addition to demand deposits. Only a small part of commercial banks’ financial activities is concerned with making payments. Banks in this payment system are pure transaction/payment financial institutions. The key elements of this alternative financial system are as follows: • Limited liability businesses are prohibited from both borrowing and lending, with the exception of lending to the government and to transaction/payment banks. • Only banks can issue demand deposits, and these deposits must be 100 percent backed by reserves held at the central bank. • The central bank holds only short-term debt on Treasury securities; therefore, demand deposits are effectively 100 percent backed by money, a form of short-term government debt. • Reserves bear interest at a rate specified by the government. Transaction banks may pay interest on deposits; however, any interest they pay is not subject to taxes. Demand deposits would effectively be interest-bearing government currency. There could not be bank runs with this system. There is no place to run to. Whenever a transaction takes place 2 between private agents, one party’s demand deposit account is credited by the amount of the transaction, and the other party’s demand deposit account is debited by the same amount. This system has two forms of government debt: debt held by the central bank and debt held by private agents. The debt held by the central bank is money. The stock of money equals the stock of demand deposits or, equivalently, the stock of reserves. The return on these two forms of government debt can be, and typically will be, different. Absent satiation, the interest rate on the government debt held by the central bank will be lower than that held by the private sector. The difference in the yields on these two forms of debt is equal to the “liquidity” services provided by holding demand deposits at transaction/payment banks. We assume that the fiscal authorities manage the term structure in such a way that the total interest paid on privately held government debt is minimized. This policy results in a flat term structure. This feature permits us to abstract from the term structure of interest rates in this study. Prohibiting limited liability businesses from both borrowing from one group and lending to another means that there will be no financial intermediaries with this system. Financial businesses would exist and would constitute a large sector of the economy. These financial businesses would make loans to households and non-financial businesses. The lenders, and not the taxpayers, would bear all default risk. One question is, “Will this system reduce the funding of businesses?” The answer is no. Currently, most financing of businesses in the United States is mutual and is not coming from bank deposits. In 2012, checkable and time/savings deposits were approximately 0.65 GNP, whereas business borrowing was 2.5 GNP (2012 Flow of Funds, Table L104-5). Nearly all of the rest of business borrowing is directly or indirectly from the household sector.3 Equity is a mutual arrangement whereby the owners of the businesses share the distributions and losses. Another part of the system is to prohibit non-mutual annuities and non-mutual pension funds. Annuities that make payments contingent on the experience of the group are mutual arrangements, which by definition cannot become insolvent. Some problems would arise when insurance companies enter into contracts that under certain contingencies cannot be honored. Permitting only mutual insurance companies would be one mechanism to mitigate this problem. Regulation of insurance companies is less than perfect, and insurance company failures would continue to occur. Such failures, however, do not give rise to systemic risk and runs on mutual insurance companies. The time-inconsistency problems would lead to taxpayers bailing out those with insured losses that are defaulted upon. 3 There could be some borrowing by business from the government. 3 In this paper, a simple model is developed and used to explore the consequences of various monetary policy regimes under our alternative financial system. The model treats the services of real money as an input to the aggregate production function, resulting in money being incorporated into valuation theory. Others have proposed having money as an input to the aggregate production function,4 but they have not worked out the implications of using valuation equilibrium theory, as we do here. It turns out that having money services as a factor of production necessitates significant revisions to the national accounts. We begin with a set of national accounts and construct a model economy that is consistent with these accounts. We examine the balanced growth path for a set of monetary policy regimes. We keep constant the public-consumption share of output and the lump-sum transfers to households share of output. We do this in order to focus on the consequences of alternative monetary policies and not on the consequences of alternative fiscal policies. Monetary and fiscal policy cannot be totally separated, as shown by Sargent and Wallace [1981]. The monetary variables we focus on are the inflation rate, the size of the money stock, and the interest rate paid on money. As the inflation rate enters the government accounts, differences in the labor income tax rate are associated with policies with different steady-state inflation rate targets. Interest rate targeting regimes will have different inflation rates, which has consequences for the key balancing condition in the government accounts that expenditures equal receipts plus the deficit. As we stated previously, it is impossible to completely separate fiscal and monetary policy because inflation has tax consequences. We emphasize that this is an exploration study. It is designed to foster the examination of possible monetary system reforms. Before any financial reform is implemented, we should be confident as to how that monetary/financial system will operate. Currently, established theory cannot be used to make such predictions. The trial-and-error approach that characterizes current monetary policy is fraught with danger, leading us to the thesis that better theory is needed. 4 Some of the other papers that have proposed money being introduced into the production function include Sinai and Stokes [1972], Fischer [1974], and Orphanides and Solow [1990].
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